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Deepening insolvency is often asserted as an independent state law cause of action against a debtor’s advisers for actions taken in their attempt to prolong the life of a failing company to the detriment of such company and its creditors. Because state law decisions involving deepening insolvency remain sparse, many bankruptcy courts are forced to predict how the state’s highest court would rule. As Delaware continues to have one of the most active business bankruptcy caseloads in the country, practitioners naturally look to Delaware law as a benchmark. To the dismay of many plaintiff lawyers, the Delaware Supreme Court recently issued a ruling affirming the holding, and adopting the reasoning, of the Delaware Court of Chancery in Trenwick America Litigation Trust v. Ernst & Young LLP, wherein the Chancery Court ruled, among other things, that Delaware law does not recognize any cause of action for “deepening insolvency.” In Trenwick, the plaintiff was a litigation trust, Trenwick, that had been appointed under a bankruptcy plan of reorganization for a publicly traded insurance holding company. Trenwick, together with its chief U.S. subsidiary (Trenwick America), had undertaken a growth strategy that contemplated a series of acquisitions with other British and Bermudan insurance firms. In connection with these acquisitions, Trenwick became obligated for increasing amounts of debt. To secure a portion of this debt, Trenwick pledged the assets of Trenwick America. When the number and amount of claims against the merged entities exceeded the estimates Trenwick had relied upon in entering into the mergers, Trenwick was unable to both satisfy the claims and service its increased debt burden. Trenwick’s resulting financial situation forced it and Trenwick America to commence bankruptcy proceedings. Once in bankruptcy, Trenwick America achieved confirmation of a plan of reorganization pursuant to which the litigation trust was appointed and empowered to pursue claims on Trenwick America’s behalf. The trust filed a complaint against directors of Trenwick and Trenwick America, and against their advisers, alleging that the directors, in pursuing their strategy of growth by acquisition, had injured Trenwick America and its creditors because they had pledged assets of Trenwick America to secure the debts of Trenwick, thereby rendering it insolvent. Under this theory, the trust alleged causes of action against the directors of breach of fiduciary duty of care, breach of fiduciary duty of loyalty, fraud, and conspiracy. The trust argued that the directors owed to creditors of Trenwick America the duty of ensuring the satisfaction of as many claims against Trenwick America as possible, because its assets had been pledged to secure the debts owed by Trenwick and other subsidiaries, thereby rendering Trenwick America insolvent. Finally, the trust alleged that the Trenwick America directors were liable for the tort of “deepening insolvency” by increasing the indebtedness of Trenwick America in connection with the acquisition of other insurance businesses. The defendants moved to dismiss the complaint for failure to state a claim, and the Chancery Court granted the motion. The Delaware Supreme Court has now upheld this ruling and adopted the reasoning applied in the Chancery Court’s opinion. In so doing, the Supreme Court has solidified several principles of Delaware law that are likely to significantly impact Delaware’s corporate law and creditor’s rights jurisprudence. The Chancery Court affirmed the principle that “[u]nder settled principles of Delaware law, a parent corporation does not owe fiduciary duties to its wholly-owned subsidiaries or their creditors.” The court reasoned that it is entirely proper for a parent corporation to sell, or pledge as an asset, property of a subsidiary to satisfy or guarantee debt incurred in connection with an acquisition. The court also held that, even had the complaint been filed on behalf of Trenwick itself (rather than on behalf of the subsidiary, Trenwick America), the complaint would have been deficient. The court reasoned that there were no allegations that the mergers constituted self-dealing, had been made without the support of independent directors and shareholders, nor that there were any deficiencies in the deliberative process that the directors used to evaluate the mergers. Given the lack of allegations in that respect, the court held that “[t]o allege that a corporation has suffered a loss as a result of a lawful transaction, within the corporation’s powers, authorized by a corporate fiduciary acting in good faith pursuit of corporate purposes, does not state a claim for relief no matter how foolish the investment may appear in retrospect.” Perhaps most significantly, the Delaware Supreme Court upheld the Court of Chancery’s ruling that Delaware law does not recognize a cause of action for “deepening insolvency.” The complaint had asserted a claim against the Trenwick America directors alleging that they had expanded the amount of debt undertaken by Trenwick America and increased its insolvency until it was forced to file for bankruptcy. The Chancery Court, however, held that “Delaware law imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate. Even when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm.” The court reasoned that any recognition of a cause of action of ‘deepening insolvency’ would “fundamentally transform Delaware law” because it would subvert the business judgment rule: “If the board . . . acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success.” The court was careful to note, however, that the rejection of this cause of action does not absolve directors of responsibility with respect to insolvent corporations. Rather, the court held, plaintiffs seeking to impose liability upon a company’s directors for the firm’s failures must rely upon the traditional Delaware “causes of action for breach of fiduciary duty and for fraud,” and the court noted that relief could also be available under state and federal fraudulent conveyance statutes. The court reasoned that these types of claims, which have been “carefully shaped by generations of experience,” strike the proper balance between society’s need to protect investors and creditors with the imperative to protect directors so that they may pursue wealth-seeking business strategies in good faith. The court also found the concept of deepening insolvency illogical. Why, the court inquired, should there be a cause of action arising from a business decision resulting in a loss only when the business is insolvent, as opposed to when the company is operating in the black. “If in either setting the directors remain responsible to exercise their business judgment considering the company’s business context, then the appropriate tool to examine the conduct of the directors is the traditional fiduciary duty rule.” Affirmation of the Trenwick decision represents an important clarification regarding deepening insolvency. It would not be surprising to see other state courts follow Delaware’s lead, thus reducing deepening insolvency to a theory of damages as opposed to a stand-alone cause of action. FRANCIS J. LAWALL , a partner in thePhiladelphia office of Pepper Hamilton, concen-trates his practice in national bankruptcy and reor-ganization matters. He routinely lectures to variouscreditor groups concerning general bankruptcyissues, including preferences, reclamation, the role ofcreditors’ committees and related issues. JAMES C. CARIGNAN is an associate in theWilmington office of Pepper Hamilton. He concen-trates his practice primarily in the areas of bank-ruptcy, reorganization, creditors’ rights and out-of-court workouts.

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